Top 400: A painful legacy
Technology has often been way down the agenda for pension fund managers. With other factors taking priority such as meeting increasing liabilities, searching for yield and achieving regulatory compliance, technology has frequently been left at the back of the queue when it comes to allocating resources.
This has been the case for many years, resulting in decades of under investment. Many pension fund managers, whether in-house or external, are consequently operating on software that was developed in the 1980s and 1990s that has been tweaked, had workarounds added and been plumbed into other systems piecemeal ever since. The net result is that the so-called legacy systems now comprise a patchwork of overlapping and ancient technology that is unable to cope with the complexity and rapid pace of today’s markets.
Legacy systems are problematic in financial services. Retail banking, for example, has suffered numerous recent outages due to its ageing infrastructure, to the extent that the UK’s Prudential Regulatory Authority (PRA) is now calling on banks to address the issue. In April 2014, Andrew Bailey, CEO of the PRA, even urged banks to rip their systems out and start again, rather than bolting bits together to create a complex but unstable structure.
RBS in particular has suffered embarrassing and costly system failures, such that it has now committed to make a significant contribution to remedying the situation, which media estimates have placed as high as £1bn (€1.8bn). This February, the bank announced it would be redirecting its technology investments, stating it was “maintaining a similar level of investment spending but directed at customer-facing process improvements, instead of maintaining inefficient legacy infrastructure”.
This hits the nail on the head – legacy systems are inefficient and costly to maintain, using budgets that could otherwise be used for investment in better technology. They hinder business progress rather than enable it.
Pensions funds are clearly facing different challenges to the retail banking world, but this does not mean they cannot learn from it.
Historically, consumer-facing technology in pension funds, from the perspective of giving stakeholders online access, has lagged behind progress in other areas of the financial services industry. It will be challenging to improve these interfaces without overhauling the investment management systems that sit just a step or two behind them in the processing chain. Improving technology at all levels is an essential part of that evolution in digitising the entire industry.
This is something pension funds need to consider, particularly those choosing to bring investment management in-house. Those beginning with a clean slate, with no legacy technology burden, have an exciting opportunity to choose how they structure their systems from the state-of-the-art options currently available. This has the potential to put them at a competitive advantage over their peers trying to manage investments on outdated systems.
Research has shown that this advantage can be significant from a performance perspective. One large Canadian pension fund which replaced its legacy technology in 2010 to help process derivatives and other new investment instruments enjoyed an investment return of 17.1% in 2012. This was driven by more sophisticated modelling and risk management processes, in addition to the delivery of daily reports reviewing exposure to credit, liquidity and counterparty credit. Such features are essential to allowing the investment manager to act quickly and be sufficiently well-informed to manage risk effectively.
Legacy systems struggle to deliver frequent, accurate reporting because their silo structure means they are fed by multiple data sources. Without a single, clean source of data, it is near impossible to gain a timely overview of investment positions and risk exposure.
Putting performance to one side, this has significant implications for the management of counterparty risk. Were a major market player to collapse, it would take many funds (or their external managers) days or even weeks to identify their exposure to that entity, and more importantly what losses they and their stakeholders may be facing. In addition, it renders effective credit risk management extremely problematic if managers cannot even estimate their exposure to a single institution on a day-to-day basis.
This issue has been exacerbated by a shift to new, and more complicated, investment instruments, such as derivative products, as investment managers seek new sources of yield. However, these carry more complex requirements from both a regulatory compliance and risk management perspective. Legacy systems are ill-equipped to cope, and so back offices typically end up resorting to error-prone manual processes and costly workarounds.
A recent survey of 44 buyside firms, conducted by SimCorp in partnership with Tabb Group, found that this issue is causing major problems. Some 75% of respondents said that they were currently unable to process newer, more complex securities, such as swaps and other derivatives, without multi-step manual interventions. This is compounded by the use of spreadsheets, which are susceptible to inaccuracies and cannot handle complexity.
Astoundingly, given the central role data management now plays in investment firms, 88% of respondents said that they still rely on spreadsheets to manage some front, middle or back-office processes.
Spreadsheets carry particular risks in respect of complying with new regulation, which is more demanding from a reporting perspective. When pension funds come to consider using derivatives, especially, there is a plethora of new rules that they need to take into account. For example, the first reporting deadline for the European Market Infrastructure Regulation (EMIR) came into force in February 2014, and requires reporting within a daily timeframe to the regulator when derivatives products are traded or terminated.
Complying with this raft of regulation will be costly and resource-intensive for firms that try to cope without automated processes in place. While it may initially seem counter-intuitive and difficult to justify, the ‘rip it down and start again’ approach will be cheaper in the long run than attempting to maintain a patchwork of legacy systems. Putting to one side the intrinsic business benefits, which pay their own dividends, keeping a legacy system running can incur significant ongoing maintenance costs. A study by the SimCorp StrategyLab, published in September 2013, referenced a global survey of buy-side firms which showed that well over half of respondents with legacy systems (56%) have had to increase overall IT operation budgets. By contrast, 60% of respondents with state-of-the-art technology systems plan to maintain or decrease IT spend.
This does not change the fact that it is a challenging conversation to have with whomever controls the purse strings. Making the case for a significant outlay in technology is no easy task. However, funds whose investment managers continue to attempt to operate on legacy systems will find it becomes untenable.
Ultimately, technology will have to be modernised if it is to be fit for modern purpose, particularly to have adequate oversight of risk. Given the heightened regulatory interest in outdated infrastructure in financial services, they may not find they have a choice much longer.
Peter Hill is managing director at SimCorp